I recently received some thoughtful comments and questions from a client who is weighing the benefits of both the active and passive (indexing) investment approaches.  I felt my responses may be helpful to others with the same thoughts/questions.

Investor:  “I've more or less concluded that markets do possess inefficiency, but it's typically really tough to find, because the search is so brutally competitive, so it seems safe to say that markets are reasonably efficient.  Managers who find the inefficiencies and beat the market are extremely scarce or extremely secretive.  I can think of Buffett, Lynch, and Templeton, but after that, I'm all out of names.”

TB: Interestingly, the important inefficiencies are most often structural.  The short-termism that prevails in our society today, and in the capital markets specifically, gives patient active managers a chance to make excess returns.  As you know, lengthening the time frame and investing on that basis is very hard for money managers to do, but if they can, the indexes are there to be beaten.

Other structural factors relate to industry weightings, capitalization ranges, and liquidity.  In the first case, widespread adherence to the benchmark weightings (indexers and closet-indexers) creates opportunities for active managers.  In the second, the small-cap market is less efficient due to lack of research coverage.  And with regard to liquidity, a patient provider of liquidity can make excess returns when ‘un-economic’ sellers are willing to part with their shares at any price.

Investor: “The real question is, given how hard it is to beat the market, and given that 80% of active funds are beaten by their appropriate index, what's wrong with going for beta?  The hunt for alpha seems tricky, expensive, very risky, and usually doomed.”

TB: We think ‘most’ ETFs are good.  And we can’t argue as to how hard it is to beat the market.  But I think we have to be careful with the active vs. passive comparisons.  To me, the studies have both apples and oranges in them.  First of all, most studies don’t impute a price to indexing (MERs on ETFs; administration and commission costs).  While those costs aren’t major, if included they move the bar a fair bit.  And second, there are too many products in the survey that are high fee (most funds) and are not managed as truly active funds (i.e. closet indexers). 

Investor: “I've read on your website some of how you chose your investment managers, but details are scanty.  What is it that convinces you, at the end of the day, that these managers produce genuine alpha, over the long haul?”

TB: There are no guarantees obviously.  I looked for experience first and foremost and as you’ve read, we were uncompromising in looking for managers that ignored the index (in the short term) and ran concentrated portfolios.  Along with a reasonable fee, we like our chances of beating the index.

But there is another appeal to active management beyond ‘searching for alpha’.  We wanted our funds to have a pattern of returns that is more suitable to individual clients.  In other words, we don’t mind if we lag behind the indexes in the frothy markets (returns will still be good) if we can weather the storm better in the down markets.  That is a tradeoff we are willing to make.  We would expect our funds to be less volatile than the indexes.

In addition to these responses, we included links to a number of pieces we have on our website that address the active versus passive debate.

The debate is sure to continue, but at the end of the day, if you stick to your investment plan, watch your fees, choose sensible products and maintain a long-term view (as motherhood as that sounds), you’ll prosper under either approach.